Adjusting Entries (Explanation)

Introduction to Adjusting Entries

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To demonstrate the need for an accounting adjusting entry let's assume that a company borrowed money from its bank on December 1, 2018 and that the company's accounting period ends on December 31. The bank loan specifies that the first interest payment on the loan will be due on March 1, 2019. This means that the company's accounting records as of December 31 do not contain any payment to the bank for the interest the company incurred from December 1 through December 31. (Of course the loan is costing the company interest expense every day, but the actual payment for the interest will not occur until March 1.) For the company's December income statement to accurately report the company's profitability, it must include all of the company's December expenses—not just the expenses that were paid. Similarly, for the company's balance sheet on December 31 to be accurate, it must report a liability for the interest owed as of the balance sheet date. An adjusting entry is needed so that December's interest expense is included on December's income statement and the interest due as of December 31 is included on the December 31 balance sheet. The adjusting entry will debit Interest Expense and credit Interest Payable for the amount of interest from December 1 to December 31.

Another situation requiring an adjusting journal entry arises when an amount has already been recorded in the company's accounting records, but the amount is for more than the current accounting period. To illustrate let's assume that on December 1, 2018 the company paid its insurance agent $2,400 for insurance protection during the period of December 1, 2018 through May 31, 2019. The $2,400 transaction was recorded in the accounting records on December 1, but the amount represents six months of coverage and expense. By December 31, one month of the insurance coverage and cost have been used up or expired. Hence the income statement for December should report just one month of insurance cost of $400 ($2,400 divided by 6 months) in the account Insurance Expense. The balance sheet dated December 31 should report the cost of five months of the insurance coverage that has not yet been used up. (The cost not used up is referred to as the asset Prepaid Insurance. The cost that is used up is referred to as the expired cost Insurance Expense.) This means that the balance sheet dated December 31 should report five months of insurance cost or $2,000 ($400 per month times 5 months) in the asset account Prepaid Insurance. Since it is unlikely that the $2,400 transaction on December 1 was recorded this way, an adjusting entry will be needed at December 31, 2018 to get the income statement and balance sheet to report this accurately.

The two examples of adjusting entries have focused on expenses, but adjusting entries also involve revenues. This will be discussed later when we prepare adjusting journal entries.

For now we want to highlight some important points.

There are two scenarios where adjusting journal entries are needed before the financial statements are issued:

Nothing has been entered in the accounting records for certain expenses or revenues, but those expenses and/or revenues did occur and must be included in the current period's income statement and balance sheet.

Something has already been entered in the accounting records, but the amount needs to be divided up between two or more accounting periods.

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